The Illusion of Control, Part III

In my last post I pointed out that, contrary to the claims of Modern Portfolio Theory, families who own businesses aren’t at all uncomfortable with the “single stock risk” they are taking. (I’m not counting startup companies, which mostly fail.) I also pointed out that, once a family sells its company and invests the proceeds in a well diversified portfolio, “everything goes to hell.” MPT is wrong about how people feel about owning family companies, and it is wrong about how those same people feel about owning diversified investment portfolios.

The psychology professors, however, who were right about why we feel sanguine about our companies, also have the explanation for why we feel very unsanguine about our liquid portfolios. As noted last week, we are comfortable when we feel that we are in control of our fates. And we feel like we are in control under these circumstances:

• We appear to be using skill. Families who built and ran and then sold successful companies were skillful in managing those businesses, but unfortunately they are likely to have very little skill managing liquid capital.
• We have manageable choices. We had manageable choices when we were running our businesses, but those days are long gone once we sell out and are looking at the almost incomprehensibly complex investment world. Just for starters, there are roughly 15,000 hedge funds and nearly 10,000 mutual funds.
• We are in competition. Technically, of course, we are in competition with every other investor in the world, but in reality we are acting almost completely in isolation.
• We are involved in the decision making. Well, sort of. We can make the broad strategic decisions for our portfolios, although we know full well we really don’t understand what is, or should be, driving those decisions. But most of the decisions are being made for us by advisors, consultants, money managers, hedge fund managers, mutual fund managers, private equity managers, and so on.

The solution to this problem, as I divulged last week, is to make managing money more like managing a business. Instead of focusing on our lack of skill, the vast choices we face, our ignorance about what other investors are doing and how far we are from where the rubber meets the road, we want to create the sense that we have control over the fate of our capital.

One way to do this is to (a) control those things we can actually control, and (b) hedge everything else.

Believe it or not, there are a lot of things we can control:

• We can become an educated player, gradually learning as much as we can about the business of managing capital.
• We can assemble a “council of elders.” We can call it an investment committee, an advisory committee, or whatever, but it’s essentially a group of people whose judgment we respect and who will be in the room with us when we make investment decisions.
• We can educate our children in the art of stewardship.
• We can keep our spending under control.
• We can work only with advisors we truly trust.
• We can spend at least as much time on our family’s intellectual and emotional capital.
• We can carefully manage our investment costs.
• We can emphasize opportunistic investment ideas.
• We can get comfortable with illiquidity.
• We can think long term, doing our best to understand the main drivers of global events and markets, rather than focusing on quarterly investment results.
• We can join affinity groups and learn from other families.

And we can hedge everything else:

• We can keep five years worth of spending in a safe bond portfolio.
• We can diversify very broadly—we’re not trying to get rich, we’re trying to stay rich.
• We can prepare an action plan detailing how we (hope we) will behave in a market crisis.

Finally, we can relax and be as comfortable as we were when we were managing our family businesses—it really will work out well in the end. I’ve been advising families now for more than 40 years and have known and worked with five generations of affluent families. Those who followed these precepts are still wealthy. Those who didn’t, aren’t.

Next up: On Karoshi